Are technical indicators useful?

Technical indicators come in many forms, but serve one big purpose only: do I open, or scale up my market position, or should I close it, or maybe reduce my exposure. Or perhaps it’s better to stay out of the market, because it’s hard to tell what will happen next…?

Origin and evolution

These are the fundamental questions that every trader needs to answer, and technical analysis is one way of getting it done. About 100 years ago it all started with Dow theory, Elliott Wave theory and Gartley harmonic patterns. After that, more and more chart patterns were described, but eventually, with adoption of personal computers, and development of charting software (i.e. MetaStock, TradeStation, TradingView) came the era of technical indicators. In the late 70s, most commonly used indicators like MACD, RSI, ATR or ADX were developed, laying the foundation for smoother, quicker and supposedly more robust trading signals. Evolution of moving averages from simple through exponential to filters originating in math or physics can be one example of the progress that technical analysis undergone, but the goal of such a tool stayed unchanged – did the signal of a trend change (reversal of an indicator) happen or not yet? No matter how sophisticated the tool, at the end it all comes to buy, sell or stay neutral.

Using TradeStation platform as an example of trading software, we’ll take a brief look at the range of Tradestation indicators available to the user. Almost all trading software has at least several dozens of prebuilt technical tools. TradeStation has a couple hundreds of indicators, that either plot lines, draw histograms, color the bars or display symbols above or below the bars. The list can seem rather large, but actually it’s not that big. There is other platform, like TradingView, that lets users share their ideas with the entire trading community, making the list extremely long. But quantity rarely transforms into quality – it simply adds more noise.

4 dimensions plus time

It’s probably safe to say, that over the last 30-40 years, thousands of technical indicators were developed. Few are really good, some of them are good, but most of them does nothing but answer the old questions in a slightly different manner. Why? Because over the years, the spectrum of information that can be derived from prices didn’t really change. We are still trying to establish if the market is in an uptrend or in a downtrend [MACD]? Is it overbought or oversold [RSI]? Is volatility low or high [ATR]? Is it trending, or it is chaotic and reverts to the mean [ADX]. Therefore, we can limit our analysis to 4 dimensions being trend, relative position, volatility and state/character.

Trend

Trend is the oldest concept in technical analysis, so it’s easiest to define. Using it we’ll take a look at the fifth dimension of analyzing charts being time. In technical analysis, time almost always means a lookback period to calculate the value of our indicator. Let’s assume, that we define a trend by the position of price in relation to moving average. If the price is above our average, then the trend is up, if it’s below, the trend is down. We will get different signals if we use 2-bar moving average and different with 200-bar moving average. Sometimes they will be the same, sometimes contradictory. So every time someone says that the trend is up, we need to be precise – is it a short / mid or long term trend…?

What kind of tools we can use to define trend? In TradeStation, apart from the most popular ones like MACD, Aroon Indicator or all sorts of moving averages, trader can use TrendLines Automatic or Ichimoku. But usually, the best solution is the simplest solution, so regular, or little more advanced price channel should work best.

Relative position

The second dimension that traders are working with is relative position. For this purpose, technical oscillators were developed. Most popular ones are Relative Strength Index (RSI) and Stochastic Oscillator. Some other interesting oscillators to look at are Commodity Channel Index (CCI) and Rate of Change (ROC). The difference between first two and latter two is the way they are calculated. RSI and Stochastic are capped by 0 points from the bottom, and by 100 points from the top. On the other hand, CCI and ROC are not, so trader can see get the feel of the real magnitude of a large move. And same as with trend definition, we can play with lookback period. RSI(2) will visit overbought or oversold zone more frequently, than RSI(14) or RSI(100).

Why do we try to establish relative position? Well, it depends. In an uptrend, your oscillators will often enter the overbought zone, and almost never enter the oversold zone. It’s normal – this is how the trend works. One trick that can be applied is stepping down the time ladder. If you get your uptrend direction from long term lookback, it’s good to look for the dips (indicators in oversold zone) in a mid-term. And the overbought condition can be used to scale down the position, or lock some profit by maybe selling volatility.

Volatility

The third dimension is volatility. It’s much trickier than trend or relative position, because it’s much harder to forecast or even describe. Volatility bursts are almost unpredictable. Volatility tends to cluster, which means that a strong daily move will more likely be followed by another strong move, not by a quiet day. The same thing happens on the opposite end of the volatility spectrum. The calm market is likely to stay calm for much longer than one might expect. TradeStation, like all other trading platforms, offers ATR (Average True Range) indicator, that is the most commonly tool used by traders to measure volatility. The most common approach is to plot a volatility channel around the moving average to look for either breakouts or reversals, which is similar to relative position from oscillators. ATR channel around moving average is called Keltner Channel, but a more popular variation of this tool is a Bollinger Band, which instead of ATR used Standard Deviation as a volatility measure. Volatility is also used in option pricing, so if a trader think that the volatility is high, and will go down in a future, then selling it should be profitable. On the opposite side, buying “cheap” (low) volatility can be profitable, when the market starts moving again.

Market character

Last, but definitely not the least, dimension or market analysis is market character or a current state. The idea that different markets behave differently was best described by Benoit Mandelbrot in a book “The (mis)Behaviour Of Markets”. He noticed, that some markets (financial time series) tend to produce longer and stronger moves than the others. Some markets have a lot of short term (daily) noise, some way less. In the field of technical indicators, this problem is not widely addressed. Trading software, like TradeStation, doesn’t offer many indicators that are meant to answer the question if the market is trending, or if it’s noisy. Most of the Tradestation indicators that are listed among the ones that gauge trend strength (i.e. True Trend Strength) also show direction (up/down). Pretty much the only indicator that measures strength in absolute terms is ADX (Average directional movement index). It’s not that popular as the other, but worth looking at. The best example would be an oscillator entering the overbought zone. If we are trading the market that tends to produce long and strong moves, it would be a buy signal. On the other hand, trading the market that tends to revert to the mean, the same signal would be reversed, and instead of long position (trend continuation) we would consider short position (trend reversal).

Magic mix

So, are the technical indicators useful? Well, it depends. If a trader keeps adding new tools to his toolbox, that are designed to answer the same question, then not. In such a case, all we get is more noise. But, if a trader knows what are the right questions to ask, and knows what tools can be used to do it, then yes! It’s all the matter of having the least tools possible. But not less.